An FAQ for Mainstream/Neoclassical Economists

I have received some standard criticisms from visiting mainstream economists – straw man, ignorant, economists aren’t all Milton Friedman-esque free marketeers, etc. Suffice to say I’ve heard it all before and it is rarely, if ever, accompanied by substantive engagement. So, if you are a visiting neoclassical economist who disagrees with me, please read this FAQ before you comment, as it should answer a good deal of your objections. I will update this post every so often to revise it in light of new developments.

How can you be so arrogant as to think you can debunk centuries of theory?

I’m not arrogant; I simply align with the evidence, and the fact is that neoclassical theory has failed at foreseeing, preventing and modelling the repeated crises of capitalism since its inception. After a crisis many models appear which present ‘special case’ events in which the economy destablises, but the core is always preserved and, once the crisis is over, we return to business as usual.

Furthermore, I do not claim a substantial degree of originality – I am mostly channeling centuries of what should have been incredibly damaging critique, though I will add some of my own from time to time.

Neoclassical economics isn’t even a thing! There’s economics and then there’s people like you.

(1) Methodological individualism – the economy is modeled on the basis of the behaviour of individual agents.

(2) Methodological instrumentalism – individuals act in accordance with certain preferences rankings, to attain some end goal that they deem desirable.

(3) Methodological equilibration – given the above two, economics asks what will happen if we assume equilibrium. This can be either the ‘undergraduate’ definition of equilibrium (a steady state) or the ‘DSGE’ definition of equilibrium ( a time path). In both cases the insistence on equilibrium handcuffs economists, and in both cases it is never really asked whether the economy is actually in equilibrium.

Our models seemed to do a good job in the boom – why are you throwing the baby out with the bathwater?

This implies no causal link between the boom and the bust, and reflects the fact that neoclassical models can only model the crisis as exogenous, or a result of ‘one off’ factors that destablised an otherwise stable economy. Conversely, I align with the idea that capitalism has underlying tendencies towards instability, and no special or exogenous factors need to be invoked.

The models also didn’t ‘do well’ in the boom – you don’t need economists to have an economy. In fact, aside from Keynes post-WW2, I cannot think of an example where modern macroeconomics has resulted in a policy that created widely shared prosperity. Many of the most successful modern economies had their policies designed by lawyers or engineers, such as Southeast Asia, whilst modern developed economies all developed before neoclassical economics really took off. They also generally used protectionism to do this, something to which mainstream economists object. If macroeconomics cannot be used to design good policy, what is the point in having it?

At a more advanced level, our models incorporate the things you speak of. How can you be so ignorant?

First, bear in mind that this criticism effectively concedes that econ101, which is all most people who learn economics ever learn, is flawed because it doesn’t incorporate vital elements. Economists often appeal to econ101, but what if an engineer did this? Wouldn’t you be slightly worried that he’d missed out some important nuances? No physics textbook ends without introducing friction, because then it would be useless. Yet economists generally appeal to econ101 when discussing tariffs, rent control, the minimum wage and so forth, without acknowledging that the real story is far more complex than that.

The whole notion of thinking of each interesting feature of the economy as a “friction,” and then of considering only one or two “frictions” at a time, has been very detrimental. For one thing, it makes it hard to develop a useful model of the economy, since the actual economy contains many, many “frictions” (so many that the “frictions” together are usually more important than the “frictionless” dynamics that supposedly “underlie” them). Also, the “one friction at a time” approach makes it very difficult to generate any alternatives to the classical “core theory” of Walrasian general equilibrium.

If the foundations of your theory – which are what I’m attacking – are flawed, then it doesn’t matter how many epicycles you’ve added later on. And the epicycles analogy is accurate. Macroeconomic models exist to explain basically every phenomenon, but generally only seek to explain one ‘aspect’ of the economy at a time. Models do not exist which can explain, say, the stagflation of the 1970s and the 2008 financial crisis. The DSGE paradigm is one that can be tweaked endlessly to explain any ‘deviation,’ all while the standard assumptions are preserved. Remember, epicycles were not abandoned because they couldn’t explain the orbits of planets (they can explain anything); it was because they became overly convoluted and complicated, all while preserving a core set of assumptions. In the case of DSGE, economists can’t even claim empirical verification, seeing as most DSGE papers don’t even bother to mention evidence.

OK, so what are your main problems with neoclassical economics?

In general: framing, assumptions and various notions of equilibrium. In particular: finance/banking, labour markets, utility and the theory of the firm. I have written in more detail on these elsewhere, for which I will provide links below.

Have you read Milton Friedman? The assumptions of a theory don’t matter, all that matter are its conclusions.

The fact that Friedman doesn’t properly define the word ‘assumption’ in that paper means he could be advocating any methodology whatsoever. Suffice to say, he’d love the octopus that correctly predicted world cup outcomes. Real science has clear parameters for the different types of assumption and when they are appropriate. Economics does not.

The Lucas Critique is valid but, of course, has been misused by economists. Lucas’ suggestion that we model based on the ‘deep parameters’ of human behaviour is impossible – no such parameters exist, aside from perhaps eating and reproducing. What Lucas really meant by ‘deep parameters’ was the preference-driven individualism outlined above, but this is as vulnerable to his own critique as any other postulate about human behaviour.

Designing policy will always and forever involve carefully examining the interactions between policy and behaviour, but it should never involve dismissing alternative theories out of hand ‘because Lucas Critique.’ Real scientists know that ‘more is different’, and aggregation and emergent phenomena are perfectly valid starting points. This does not become different because of economist’s special pleading.

P.S. Lucas was not the first to make this argument – Keynes did, as did Phillips himself, the main guy Lucas was aiming his critique at. It’s also worth noting that endorsing the microfoundations position and the Friedman position simultaneously is contradictory.

Even if markets aren’t all that great and people aren’t rational, how can the government improve on these outcomes?

This framing stems from the neoclassical bizzare-o world of governments versus markets. Nobody suggests that safety engineers need to be invulnerable, and similarly, designing a system in which ‘irrational’ people are better able to operate does not require omniscience. Limited liability laws are a great example of a hidden ‘intervention’ that many ignore, but work well and clearly do not require the government to ‘know better’ than market participants.

Keynes was as heterodox as they come, although his work was completely misinterpreted by people like Hicks (who, later on, admitted his mistake). He rejected exogenous money, the idea that sticky wages cause demand side recessions, and the idea that the interest rate was determined by savings and investment. He was also the first to incorporate Knightian uncertainty into economics, something his mainstream followers rarely, if ever, mention. He had not fully escaped neoclassical economics when he wrote The General Theory, but he was well on his way.

Austrians did a good job of predicting the crisis, and they are heterodox. Why don’t you pay attention to them?

The only major difference between Austrians and ‘free market’ neoclassicists is that the former do not advocate central banking. They both suffer from similar framing issues, use similar methodology and come to almost the exact same policy conclusions – it’s no surprise that they have little trouble siding with each other. For those reasons, I cannot take their cries of heterodox seriously (most of them, anyway – Lachmann and others like him have some valuable contributions). See here for my brief overview of Austrianism, and here for why I think they are similar to neoclassicals.

What are some of your major critiques?

The fact that firms barely even understand how economists model their pricing habits, let alone conform to the models; for a theoretical approach as to why, see Piero Sraffa’s paper.

My most comprehensive rejection of Friedman’s (incoherent) ‘assumptions don’t matter’ position is here.

For some notes on the accusation that heterodox economists straw man mainstream economics, see here; see here for common mistakes made by heterodox economists. See here for what I believe is the real difference between heterodox and mainstream economics.

Some less directly theoretical but still important issues are the neoclassical misinterpretation of Keynes, and the related general lack of regard for the history of thought. I also have issues with how neoclassical economics frames economic debate. Finally, I feel economists underestimate the importance of institutions.

I don’t hate you anymore because of this fantastic FAQ. Where can I find other blogs like yours?

Robert Vienneau, a Sraffian/post-Keynesian blogger. The go-to person if you want to get highly technical.

Other than myself, Robert Vienneau has various posts on Sraffian and Kaldorian models; Cameron Murray has a theory of return-seeking (not profit-seeking) firms; Econophysicists have some interesting work (though it’s not without its problems).

Overall, I broadly align with the Sraffian/Classical notion of society having to reproduce itself and this (roughly) determining prices, rather than the neoclassical idea that resources are allocated by optimising decisions and relative scarcity. On top of this, I adhere to the mark up approach of pricing (simply because it’s what firms actually do) with constant or decreasing returns to scale, and a theory of endogenous money.

P.S. If your response still contains the words ‘ignorant’ and ‘straw-man’ please consider whether you are just dredging up the standard style of response that all mainstream economists use to avoid some uncomfortable truths, and whether you have actually engaged with what I’ve said. Ignorance and straw-manning are possibilities, but after the crisis of 2008 I’d say the burden of proof lies on economists to provide robust defences of their theories, rather than merely behave as dismissive and arrogant reactionaries when challenged.

Some thoughts:
I have been looking at jobs for people with training in econ, and pricing analysts are one of the most common that keep popping up, though Information Systems is as often a preferred requirement (if not more so) than Economics, so I’m not sure how to interpret that. There is a large demand for pricing analysts, though – 15,000 in the top 50 US cities (though I could be getting some “price sticker appliers” in that).
The Valve co-founder, talking about his pricing techniques, seems at least informed by standard price theory: http://www.geekwire.com/2011/experiments-video-game-economics-valves-gabe-newell

Can you explain why increasing personal debt is necessarily a bad thing? If there’s less uncertainty in society, people will be willing to borrow more. I haven’t thought about this very much though (and the post you link to doesn’t inform me much on this point), so I may just be fundamentally ignorant of your point there.

I’m not a fan of your blithe dismissal of Austrians here, though it’s perhaps an adequate response to people who claim that Austrians ‘predicted’ the crisis. This tribalism throws out not only the “Austro-libertarians” but also the great deal of work people under the ‘Austrian’ label have done on evolutionary economics, social institutions, etc. Throwing Shackle-Lachmann-Lavoie-McCloskey (and all Hayek) out with ABCT and Rothbard-Rockwell doesn’t help your goal to transform economics. Even if you yourself don’t do that (which I think you don’t), putting the dismissal in your FAQ will turn people who trust you as an authority off from potentially useful strands of investigation under the umbrella of Austrianism.

Also, an aside: I think you misinterpret Mises’s ‘action axiom’ in other posts. To say that all action is purposeful is a methodological note, one that no policy prescriptions can be gotten from. Purposeful action only needs to serve the end that an individual is pursuing at the moment of action, given that individual’s interpretation of the world at that moment. This doesn’t rule epistemic biases, or anything behavioral economics does (which is why Vernon Smith doesn’t dislike Human Action). Mises intersperses his methodology with normative comments, which is, I think, a huge failure in presentation; but I don’t see his politics coming from his methodology. Others interpret Praxeology in the same way you do, but think it’s a good thing… you’re right to say that is essentially watered down neoclassical economics.

I look forward to reading more of your blog (I followed Kuehn’s link here).

Increase debt is bad simply if it is beyond people’s ability to pay. This occurs when borrowing does not go towards investment but to bid up asset prices or consume.

Re: Austrians, when I said ‘most of them’ I had Lachmann and similars in mind. In fact, I’ll edit the post to put that in.

Your points on praxeology: it strikes me that many Austrians rule out positivism – Mises him self said that praxeology is not falsifiable by empirical facts. That’s why I got the impression they’d reject the ‘behavioural’ approach to human action (In practice most ‘internet Austrians’ would say something glib like ‘well governments have all those biases too’).

Praxeology exists only at the level of pure theory, and has no empirical content. To make an empirical claim and say that it can’t be refuted by facts is, of course, absurd. The claim is that complex objects require pre-analytic frameworks to understand, and these pre-analytic frameworks can either be useful or unuseful in understanding the real world, but are not falsified by the real world. [The dislike of positivism comes from the claim that data can be unambiguously interpreted.]

So to say ‘human action is purposeful’ is to adopt a framework to understand the social world. Mises uses the term ‘rational’ in a different way than Weber uses “instrumental rationality.” Weber means some sort of secular-utilitarian concept of rationality (which he contrasts with ‘value’ rationality, emotional action, and traditional action), which is closer to the everyday use of rationality. Mises wants to use ‘rational action’ to mean ‘action believed to get someone closer to a desired end than the alternatives, given that person’s specific set of knowledge and specific ends, which are up to us to discover given what we observe.’ Behavioral economics (and psychology) can help us understand the way people actually learn and understand the world – it doesn’t necessarily have to match rational expectations or anything else.

The problem is when people interpret Mises’s ‘all action is rational’ in the way that Weber means instrumental rationality. From that you get Rand as social science.

Of course, if the standard usage of a word means one thing and you use it in another way, and replacing your meaning of the word with its standard usage leads to something completely different (I’m talking about Mises’s use of rational), you’re probably making a huge stylistic/rhetorical mistake and begging to be misinterpreted. And if people purposefully jump between the two different definitions to win an argument (as Quiggin has criticized), then you’re also doing something wrong.

Yes perhaps praxeology retains some epistemological usefulness ,although I still have to say that a tautological evaluation of human action doesn’t really appeal to me. The problem is that internet Austrians weave between the two definitions, as you say, which creates a large amount of incoherence.

The heterodox Keynesian economist Dean Baker clearly identified a housing bubble in August 2002 and predicted a serious economic crisis coming from the collapse of the bubble (in a Center for Economic and Policy Research paper):

The best the Austrians have is the early identification of the housing bubble by Ron Paul in a speech to the US House of Representatives on September 5, 2001. But even here Ron Paul made a number of FAILED predictions, so his predictive power was hardly spectacular.

Only 2 other Austrians identified the emerging housing bubble before Baker, but only a few months before Dean Baker’s paper was published in August 2002, and Baker himself must have been coming to the same conclusion in these months. So these Austrians just displayed much the same insight as a progressive Keynesian economist.

(1) All in all, the Austrians did not show any great power in predicting the crisis at all: after about 2003 many people, including heterodox Keynesians and maverick neoclassicals were predicting some kind of serious economic trouble.

(2) the Austrian trade cycle theory in does NOT explain the 200s boom or bust.

Fair point, I just wanted to put something about the Austrians in there to deter them.

‘(2) the Austrian trade cycle theory in does NOT explain the 200s boom or bust.’

I have been searching high and low for a post I saw on MR a year or so ago. Basically, the jist was that at the peak of the housing bubble, people were simply buying and selling the same houses rather than building new ones. This is important, because although you could still accept the idea that low rates caused this to happen (I don’t), the Austrian prescription of liquidation does not follow as capital was not misallocated; just transferred between different owners.

“Basically, the jist was that at the peak of the housing bubble, people were simply buying and selling the same houses rather than building new ones. “

That is a very important point and shatters their ABCT ramblings.

I mean apart from the vast number of othe rthings that make the theory untenable, when many of these mortgages loans were refinancing and home equity loans, and the money obtained from the debt not used for new housing construction at all, but to pay credit card debt down or purchase more consumer goods, you have a very different phenomenon going on from (imagined) capital goods malinvestments in higher order stages of production.

This is not meant as a criticism but just a comment on what non-economists (like me) feel. All economists seem to think that growth is important, but I’m not clear where it comes from or what can be done to promote it. I think (maybe wrongly) that many elected politicians share my ignorance.

It comes from technological progress and the division of labour – basically, increased productivity. I’m sure you’re aware that if you get a group of people to undertake specific aspects of a task they will be far faster than if they all tried to perform the entire process individually. Adam Smith used the example of a pin factory. Typically wordy:

To take an example, therefore,*19 from a very trifling manufacture; but one in which the division of labour has been very often taken notice of, the trade of the pin-maker; a workman not educated to this business (which the division of labour has rendered a distinct trade),*20 nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them.*21 I have seen a small manufactory of this kind where ten men only were employed, and where some of them consequently performed two or three distinct operations. But though they were very poor, and therefore but indifferently accommodated with the necessary machinery, they could, when they exerted themselves, make among them about twelve pounds of pins in a day. There are in a pound upwards of four thousand pins of a middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. Each person, therefore, making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day; that is, certainly, not the two hundred and fortieth, perhaps not the four thousand eight hundredth part of what they are at present capable of performing, in consequence of a proper division and combination of their different operations.

Population growth also helps as you have more people producing stuff. Obviously, though, it doesn’t do much for per capita GDP.

I’d like to suggest some reasons to suspect that the claim is not yet sufficiently well-evidenced to make refutation the correct requirement. If the link you provide is the best evidence you have then it may be wise to be less wholeheartedly committed to the hypothesis.

(a) A point of pedantry: Keen is talking about growth in private /deficits/, not simply private /debts/. Biggs et al. make this point quite clearly in their paper.

(b) Keen seems to be presenting some new claims for correlation. It’s always nice when econometricians don’t bother their pretty little heads about p-values, or similar niceties; it’s not like they’re trying to persuade people this isn’t just accidental or random covariation.

(c) When Keen graphs ‘acceleration’, ‘speed’ and ‘level’ together it is clear by inspection that his claimed first derivatives are not: the zeroes and critical points do not align properly. I can hardly take his claim to have calculated ‘acceleration’ seriously when it so plainly isn’t one. In the absence of correct calculations here, it is hard to see how any claimed relationship can be believed.

As I say, this isn’t passing judgment on the claim itself. But I don’t think I would buy it on the basis of the evidence thus far presented.

Even if markets aren’t all that great and people aren’t rational, how can the government improve on these outcomes?

This framing stems from the neoclassical bizzare-o world of governments versus markets. Nobody suggests that safety engineers need to be invulnerable, and similarly, designing a system in which ‘irrational’ people are better able to operate does not require omniscience.

Kind of like what I commented on an earlier post: I think if you narrow your criticism to a specific subset of “economics” it will be more powerful. There are plenty of models that answer a very specific policy question and do it well. Both theoretical models (look at the glomm / ravikumar paper on isomorphismes.tumblr.com) and applied ones (for example a monograph about a particular int’l trade issue by trade.gov is going to be much more fact-based, talk about the interests of actual parties, etc).

The real issue — if I understand what you’re po’ed about — is in the generalistic, sweeping, hemi-philosophical “standard assumptions” that [a] commentators and [b] people who know only a little economics — people who think that an excellent grasp of Econ 101 concepts allows them to be right about everything that’s going to happen in the world, rather than just have a good place to start.

Personally I have a lot of problems with utility theory / choice theory / micro foundations. But I don’t think you are really writing against micro. So I would further suggest delimiting the criticisms to just macro.

(This has the further benefit that you will now have a majority of academic economists and even macroeconomists on your side agreeing that macro is bullsh*t.)

I appreciate your advice but for me micro is just as bad. The neoclassical theory of the firm is a load of nonsense and supply demand is an incredibly glib way of representing how resources are allocated by prices, not to mention it completely ignores changing expectations.